Cost of capital is the expected rate of return on an investment compared to the potential return from selling it. Investors aim to recover their initial investment and generate a positive cost of capital. Researching investment opportunities increases the chances of realizing a rate of return.
Cost of capital is essentially another way of identifying the opportunity cost associated with a particular investment. In other words, the cost of capital has to do with the amount or rate of return that can be expected on the investment, relative to what would be realized by selling off the investment. Investors routinely consider the cost of capital when projecting the potential profits that can be realized by choosing to invest in a given issue of stock or bond.
When an investor chooses to make an investment, there is usually an expectation that two specific events will occur. First, the investor will recover the principal amount initially used to purchase the bonds or shares involved in the transaction. Therefore, it is anticipated that the investor will not actually suffer a loss as a result of the acquisition. In general, investors do not invest in securities that offer little or no hope of recovering their initial investment, as this represents negative opportunity costs and defeats the purpose of the investment.
In addition to recouping the initial investment, the typical investor also hopes to reap a return on the securities acquired. Depending on the investor’s strategy, this may include a short period where the investment actually loses money before the stock stabilizes and begins to increase in value. But the ultimate goal is that the investment generates a positive cost of capital. That is, the investor seeks to realize a rate of return that not only exceeds the initial acquisition cost, but also earns him or her a significant amount of financial rewards that help offset the time and effort put into the investment strategy.
Since the primary purpose of investing is to make money rather than lose it, investors and brokers will pay close attention to the history and future potential of any given investment opportunity. In this way, the chances of realizing a rate of return and therefore generating a positive cost of capital are much better than in the case where no research is done on the security’s potential.
Smart Assets.
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